The legal landscape for oil traders continues to present significant challenges for the unwary. Although the oil price has recovered from previous lows and is now around US$54 per bbl, the scope for fluctuation remains significant, though industry participants are not predicting an imminent return to levels much above US$60-70 per bbl. Recent press articles suggest that shale gas production in the US that had slowed or shut down when faced with the very low prices we saw last year are starting up again; the prospect of deregulation in a Trump-led US also suggests that production might increase. In addition, levels of oil in storage remain high which adds a further level of complexity and producers continue to struggle with a lack of investment that has made a return to risky prepayment deals more likely. The slowdown of demand in China also seems set to continue and may well feed into an increase in counterparty risk.
Another factor that continues to play into a difficult market is the ripple effect associated with sanctions, whereby the fear of being in breach has a continuing impact even when the overall scope of sanctions is reduced. In the case of Iran, the inward investment in infrastructure upgrades needed to deliver significant quantities of oil to market has not yet materialised. Although Iran is reportedly close to announcing the full terms and conditions of a new oil and investment contract that is intended to replace previous buyback oil deals, the experience of recent sanctions and uncertainty surrounding the future may create difficulties.
Overall the picture remains uncertain and with that uncertainty experience suggests some key legal risks to which traders may become exposed. With this in mind, the question arises as to what sort of disputes can we expect and what can be done to manage the risk of such disputes?
Continued issues around non-performance
In an uncertain market, deals can rapidly become less attractive to a particular party, especially where we see continued oil price volatility as opposed to a continuing upward trend. Parties facing liquidity issues or who are committed to contracts that are not as profitable as they were expected to be are increasingly alert for any opportunities to avoid performance or escape from their obligations. In such cases we tend to see arguments from counterparties challenging the existence or validity of the contract or seeking to reject the goods and terminate the contract.
Given the commercial pressure under which traders operate, it is not uncommon for situations to arise where there is a lack of clarity as to when a contract has actually been formed and what its terms are. The result is that each side can end up with a different understanding of what was agreed or how a court or arbitral tribunal would go about deciding what the terms meant. In the good times, when both parties have an interest in making a deal work, such uncertainty is much less likely to be exposed or relied upon. However, as soon as one party runs into financial difficulty and seeks to escape from the deal, such issues become critical.
In addition, it is not uncommon for traders to misunderstand the extent to which either they or their counterparty may be entitled to reject goods. It is not as easy as many people think but is nevertheless not an uncommon problem to arise.
Difficult and uncertain trading conditions will often result in disputes arising out of insolvencies. Experience indicates that insolvencies can often have a fraud dimension and that oil storage can be a particular area of fraud exposure in an oil trading context. Such problems can become increasingly complex where floating storage is utilised. Many organisations risk exposure as a result of poor practices and inadequate controls which developed during the good times. If liquidity continues to be an issue, those practices are unlikely to guard against the impact of insolvencies and an increase in instances of fraud.
Although they have been reducing recently, oil storage levels remain very high even though recent changes in the market structure have seen movements away from contango towards backwardation. Market estimates suggest that over 50 oil tankers are currently being used for storage and although this number is down from the estimated total of 75 vessels earlier in the year, this remains a significant feature of the current market.
A key problem when things go wrong is a lack of accurate monitoring of oil stocks in storage and clarity in the method of storage adopted. Poor facility management can result in theft, misappropriation or misallocation. While it is safest to have clear segregation of the oil, this is not usually practical and in reality most stored oil is co-mingled or even blended. Where an insolvency of the storage facility occurs, or of a counterparty which makes use of such storage, this can be a significant complicating factor and a major feature of the ensuing litigation is often the resolution of competing proprietary claims to cargoes that are recovered. Such disputes tend to arise between innocent (and solvent) parties affected by fraud and/or insolvency – for example disputes over title to goods where the only way for multiple parties to recover their losses is by establishing ownership over the same asset. Corruption is also an area of concern and may result in greater difficulties in enforcement even when litigation has been successful.
What can traders do?
A key message for traders would be to tighten up their practices in relation to contracts and, in particular, to consider the following:
- Contract formation: don't stop half way.Follow up after the recap and get it all in writing.Many disputes arise where parties think that the contract is the last wording that they sent across, whereas in reality it is essential to be able to demonstrate agreement in order for the other side to be bound.In certain instances the law can fill gaps in an agreement where appropriate, but achieving this can be an expensive and unpredictable process, so why leave it to chance?
- Focus on rights to reject: traders should think carefully about whether they intend the counterparty to be able to reject for a breach of product specification and to reflect this in the contract.It's not as simple as many think and the mechanism, together with the relevant spec itself, should be clear.
- Keep an eye on the counterparty's financial stability – are they sound? Can security be obtained?Are there appropriate triggers for cancellation in the contract to avoid having to deliver to a party that has or is about to become insolvent? Even if the contract does not provide a mechanism for cancellation, or where the exposure has already arisen, there may still be advantages to be gained commercially or under relevant insolvency law by acting quickly and seeking to restricting any exposure at an early stage.
Where storage is an issue it is advisable at an early stage to gain a clear understanding of the applicable law of the country in which the facility is located – something that may not always be straightforward in the case of floating storage. Security or proprietary interests in the goods should be protected under local law wherever possible and this should be reflected where necessary in the storage arrangements. Even then, it is very much a matter of risk management given that some jurisdictions are more reliable than others. Care should also be taken concerning insurance arrangements: the terms of cover require careful scrutiny, with particular regard to whether all the anticipated risks are covered, including the effect of local law upon interpretation of the policy.
Even in difficult market conditions, experienced players in the oil market will find ways to operate effectively and even to prosper. The Financial Times recently reported that the top five independent oil traders, including some of the world's largest independent commodity houses, have increased their oil trading volumes by more than 65% during the recent oil price slump. While opportunities undoubtedly exist for successful trading even in times of market uncertainty, a number of legal traps can await the experienced operator and unwary alike. Counterparty risk, insolvency and fraud can result in significant exposure and represent serious risks. However, as we have seen, there are a number of practical steps that can be taken to mitigate and manage such risks. In particular, the tightening up of practices in relation to the conclusion of contracts can significantly improve the position when faced with non-performance and the potential risks of oil storage as part of a trading position must be carefully understood and appropriately managed.